Capital steps: a challenging climb

Under the gun, banks scramble to raise funds

One bank after another has been ordered by regulators in the past year to raise capital or face potential government takeover. But most, particularly small institutions, are finding that fresh money is scarce.

Banks with more than $1 billion typically have the choice of offering new public shares or raising money from private-equity investors, though both can entail significant dilution. At under $1 billion in assets, private-equity firms usually have little interest, explains Wesley Brown, managing director of St. Charles Capital LLC in Denver. At that size, he points out, there would be little liquidity in any investment.

“A $250-million-asset bank that needs to raise new money is too small for an institutional investor to bother with. It's not worth their time,” Mr. Brown says. “For these small banks, the alternative often is to pass the hat among board members and local businessmen. But that's tough to do now. Many of these people see banks as risky investments today. If a bank is near failure, they'll ask, ‘Why throw good money after bad?' “

Paul O'Connor, a managing partner at Angkor Strategic Advisors LLC in Chicago, works with small banks in raising capital. He says troubled, capital-short banks have a couple of other options available. “One is the bump-along strategy,” he says. “We'll bump along until something better happens. Maybe real estate markets will suddenly recover in six months and capital will be restored, for instance.”

The other alternative is to seek a merger. But Mr. O'Connor argues that mergers often aren't the answer: “Put together two troubled banks that are each short of capital, and what you end up with is just a bigger troubled bank.”

Peter Rossiter, a partner at Chicago law firm Schiff Hardin LLP who advises local banks, says that entrenched owners of small banks often can't swallow the shrunken valuations of their holdings. The average bank transaction today is done at about 110% of book value, half the level of five years ago. Small bank transactions sometimes take place at less than half of book value, Mr. Rossiter and others note.

“Smaller bank owners can't adjust to the reality that their stock is worth a lot less than they thought,” Mr. Rossiter says.

Michael Iannaccone, president and managing partner of MDI Investments Inc. in Oak Park, says that capital investors often demand that existing shareholders dilute their own stakes in a bank to 10% and less before investing in a troubled institution. Many bank owners refuse to accept such severe dilution as part of a capital deal.

“I tell clients, ‘Would you rather hold 100% of something that is dead three years from now or perhaps 10% to 30% of something that is still alive and valuable?' If they're smart, they'll take whatever opportunity for new capital they can get,” Mr. Iannaccone says.